Intro To Creative Accounting

Here is a good explanation of the way in which companies like WorldCom artificially inflated their net profits. This has actually been very common practice for many companies for several years. Any claim that it is a new concept is completely bogus.

I can recall dozens of stories during the late 1990s dot-com stock hysteria where it was reported that companies such as AOL and Amazon were routinely capitalizing marketing and other operating costs that should have been included in normal expenses. Every few years, in order to clean up their balance sheets and please their outside auditors, they would take an extraordinary charge for a huge amount, as WorldCom & Xerox recently did. The sneaky strategy behind this maneuver was that most investors and stock analysts valued share prices based on "normal" earnings and did not penalize them for extraordinary charges, such as writing down the values of fictitious assets. Some analysts were able to see through this scam and valued the stocks accordingly. Others, who didn't understand the true nature of extraordinary charges, were fooled.

Here's a brief accounting lesson for those of you curious as to what an extraordinary charge should be. It is meant to be used only for large expenses that were unusual & unexpected in nature. Losses from catastrophes are properly reported as extraordinary expenses because they are freak events. The write-down of improperly capitalized expenses, as WorldCom and Xerox are doing, does not fit that description by any stretch of the imagination. It was routine and completely expected.

This trick has also long been used by our rulers in DC, which is why they were able to claim that they had balanced the annual budget, yet the overall Federal debt was still climbing. They have been moving more & more types of expenditures out of the normal operating budget and into non-accountable extraordinary expense categories. It is absolutely no different from what WorldCom, Xerox, et al have been doing. That is why I scoff at demands by our esteemed rulers in DC that corporate America clean up its act with its accounting. Hypocrisy of the highest level.

Lou Dobbs has a good look at how our rulers in both parties are trying to exploit the recent creative accounting scandals for their own power grabs.

Income Taxes
This entire issue points out the different goals of financial statements. For lender & investor purposes, we want them to paint a picture of a money making machine. However, when it comes to reporting to IRS, we normally try to expense as many things as quickly as possible in order to appear to be making the least amount of profit. At first blush, the tricks WorldCom, Xerox, et al were playing should have also artificially inflated their income taxes. That would be true if they didn't keep two sets of books, which is standard practice for large corporations. I can still recall learning how to account for the income taxes on the difference between the two sets of figures in my early accounting classes at Cal State Hayward almost 30 years ago; so this is not a new practice.

Are the corporate executives on the lam?

KMK
- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 6/30/2002 02:26:00 PM Send this post: